Recovery Loses Momentum

Outlook for Remainder of 2010 Darkens
Even as Businesses Post Strong Profits

ENLARGE

GDP rose at a 2.4% rate from April to June. First-quarter growth was revised up, but estimates all the way back to 2007 were revised lower.

By

Conor Dougherty And

James R. Hagerty

Updated July 31, 2010 12:01 a.m. ET

The U.S. economy lost momentum in the second quarter as consumers remained frugal and a cycle of restocking by businesses, which helped propel growth in previous quarters, showed signs of petering out.

The latest and broadest snapshot of the U.S. economy, released Friday by the Commerce Department, said that gross domestic product—the value of all goods and services produced by the economy—grew at a 2.4% annual rate in the period. That is down from an upwardly revised 3.7% in the first quarter and 5.0% in the final quarter of 2009.

The growth slowdown bodes poorly for the rest of the year, and some economists indicated they would cut growth estimates for the second half based on the report. Also Friday, the government released revised GDP numbers for the past three years, which showed the recession was worse than previously thought.

The downbeat GDP reports come as businesses are logging high profits, underscoring a wide divide between companies and ordinary consumers. With 70% of companies in the S&P 500 having reported earnings through Thursday, second-quarter earnings are running 42% higher than a year ago, even though sales were up only 9%.

The Dow Jones Industrial Average fell 1.22 points Friday to 10465.94. For the year, it has risen 0.36%.

In the second quarter, businesses increased spending on equipment and software by 21.9%, while a category that includes home building grew amid a rush by consumers to take advantage of tax credits for homes. But overall spending by consumers remained sluggish, rising just 1.6%. The first quarter's total was revised downward.

Two other reports Friday showed consumers have seen little growth in their wallets and remain skittish about the economy's prospects. The Labor Department said compensation costs rose 1.8% for civilian workers in the second quarter compared with a year ago, a sluggish pace and about half the rise in the early stages of the recession. The Thomson Reuters/University of Michigan consumer-sentiment index was 67.8 in July, up from a preliminary reading of 66.5 but still extremely weak.

Despite profit growth at businesses, the economy can't continue to grow without help from consumers, because their purchases account for about 70% of economic activity.

Bob Husband, chief executive of Heritage Golf Group, a San Diego company that owns and operates courses in six states, says profits have stabilized but he doesn't expect business to pick up until consumers feel better about their prospects. "Our business is directly related to people having jobs and having disposable income," he said.

Economic growth in the U.S. during the second quarter slowed to 2.4%, indicating that the recovery has been weaker than previously expected. David Wessel, Dennis Berman and Evan Newmark discuss. Also, Dennis Berman tells the story about one of the leaders at Tiananmen Square who is now one of the top candidates to manage Berkshire Hathaway's investment portfolio.

After slashing costs over the past three years, Mr. Husband says his company has the same level of cash flow as it did last year, despite a single-digit decline in revenue through the first half of this year. The company is using less energy and water, and has become vigilant about sending hourly workers home early on days when it rains. But despite the newfound stability, Mr. Husband says his company won't be adding workers until there are clearer signs of recovery.

"We're very hesitant to hire anybody unless we absolutely have to," Mr. Husband said. "You just want to have enough money in the bank to withstand another downturn."

GDP growth in the second quarter was bolstered by several factors that are likely to be temporary. Spending by state and local governments added to growth in the latest period, but that factor is likely to fade as governments grapple with budget gaps and begin to see federal stimulus dollars fade away.

Inventory growth contributed just more than one percentage point to GDP, less than half the contribution it made in the first quarter of 2010 and the last quarter of 2009. Inventory building—the result of companies moving to restock shelves depleted during the deep recession—has been a driver in the previous two quarters. The slower second-quarter pace suggests that the restocking cycle is at or near its end.

"It suggests less growth in the second half," said Ben Herzon, an economist at St. Louis Forecasting firm Macroeconomic Advisers.

The report showed imports and exports both grew, but imports grew faster, shaving a net 2.78 percentage points from GDP growth. Still, the strong demand for imports is a good sign: It indicates growing domestic demand. Indeed, final sales to domestic buyers grew 4.1% in the second quarter, the fastest pace since the first three months of 2006, before the recession.

The second-quarter slowdown in GDP growth is likely to reinforce concerns at the Federal Reserve that the recovery is losing momentum, prompting a debate about what steps, if any, to take if the slowdown continues. But policy options look limited: Deficit angst in Congress and partisan gridlock makes any additional fiscal stimulus extremely unlikely unless the economy deteriorates further.

Meanwhile, it remains to be seen whether the profit surge can continue without a broader upturn in jobs and consumer spending. Many businesses have logged higher profits thanks to demand growth from better-performing economies overseas and by finding new ways to keep labor and other costs low.

One of them is Timken Co., a Canton, Ohio, maker of roller bearings, gear boxes and other industrial goods, which on Thursday reported a 37% jump in second-quarter sales and raised its profit forecast for the year. Timken has seen stronger demand—including a $26 million order from China for wind-turbine equipment and services—and has hired about 500 people in the U.S. this year. As of June 30, Timken had nearly 17,000 employees world-wide.

ENLARGE

But new software and more efficient procedures for handling inventory and raw materials mean the company has eliminated some jobs for good. The chances of returning to the employment levels of 2008 look "pretty remote," said Don Walker, a senior vice president who handles personnel.

Business investment is often followed by hiring, but that hasn't been the case in this recovery. One reason is that much of the investment is being used to maintain or upgrade existing equipment, not to produce more products, according to the Federal Reserve's "beige book" on Wednesday. Meantime, companies are investing in technology that cuts jobs.

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